Impact of Disclosure and Corporate Governance on the Association between Fair Value Gains and Losses and Stock Returns in the Commercial Banking Industry

An effective risk management process enables a bank‘s management to measure and monitor risk, generate credible data, use sophisticated tools and provide fair value estimates, potentially of higher quality. Although the actual risk management process is unobservable to outsiders, disclosure relating to the risk management activities and corporate governance that monitors it reveals its effectiveness to the market participants. Using the association between stock returns and fair value gains and losses (FVGL) as a measure of the quality of the fair value estimates, this paper investigates whether the FVGL-returns association is a function of disclosure and corporate governance for a sample of 180 US commercial banks for the period 2003-2005. I find that disclosure has a positive effect on the FVGL-returns association. The effect of corporate governance is more subtle and indirect through the medium of disclosure. Analysis by type of risk shows that the impact of disclosing modeling of interest rate risk, credit risk and derivatives risk on the FVGL-returns association is increasing in the bank‘s exposure to these risks. Overall, evidence suggests that disclosure aids market participants directly, whereas corporate governance aids market participants indirectly (via disclosures) in evaluating the quality of fair value estimates.